For two weeks in a row, beginning July 29, I sent out Options 101 articles a day earlier than typical, warning of unusual market conditions. I suggested that traders trade smaller, employing only liquid vehicles, and take other steps to control risk. Consider whether you want to open new iron condors, credit spreads or butterflies, as you might normally do when volatility expanded, I suggested. "We've had several two-standard deviation moves over recent weeks. Those are hard to tolerate in a newly opened iron condor or butterfly, before theta has had a chance to work its magic on the trade and decay the costs of the sold options."
Those troubling market conditions certainly resulted in some difficult times for traders. The markets swooned. What next? In their landmark 2005 study, "Enhanced Call Overwriting," researchers Ryan Renicker, CFA and Devapriya Mallick concluded that during a 1/97-9/05 sample period "the market rallied in 59 percent of the months" following a down month (7). Is it time to consider getting back into the market full steam?
Unusual market volatility along with some other signs prompted me to send those articles out earlier than usual. One of those other signs was the action of the TED spread, a spread that I've mentioned many times over the previous years. This is the spread between our three-month treasuries and the three-month Eurodollar. When the spread widens and the graphed line climbs, the action hints at increased default risk. Equity markets don't tend to like rising default risk. They tend to move in opposition to the TED spread.
While you can't use the TED spread as an exact market-timing tool, you can and perhaps should use it as a barometer warning of dangerous weather approaching. For example, my June 7, 2008 article, "Who Is Ted and Is He Spreading Gloom or Cheer?" noted that the TED spread's actions perhaps hinted that there was more "risk in the market than is optimal," and I thought that plans to protect bullish profits should perhaps be made.
To better understand how this has worked in the past with the TED spread, you might want to read a later article, too. That September 4, 2009 article also provides background information and charts showing other breakouts. A search of the 2008 Trader's Corner archives will turn up articles concerning this spread that I was watching with increasing alarm through 2007 and 2008.
That linked 2009 article noted that for many years, the TED spread's "traditional long-term range had been from about 20 to 50 basis points, with occasional blips down to about 18 and up to about 60." However, after the massive breakout in 2008, the TED spread sank to new record lows. Other than a several-month period in the middle of 2010, the TED spread has established a new lower channel in which it tends to oscillate.
Only, now, after a quick dip during our debt-ceiling debate, when our treasuries likely weren't considered as safe as they had previously, the TED spread has now broken higher, out of that channel.
Six-Month TED spread Chart from Bloomberg.com:
Sizing requirements render some of the text and numbers difficult to read, and the Bloomberg charts don't allow for easy drawing of channels. At the time the chart was snapped on Friday, August 26, 2011, the TED spread measured 32.79, well above the top of the channel at 26.19. Although the TED spread had pulled back by the close, Friday's reading was still its highest level and highest close in more than year. Its peak high during 2010 was 46.81, if I've read the chart correctly. I've been watching closely to see the TED spread's rapid recent rise would slow as it approached and then moved through the 30-ish range that seemed to mark its breakout in early May, 2010, but so far that rise has not slowed.
How high can the TED spread go? Obviously, much higher. However, as my 2008 and 2009 articles pointed out, the TED spread once moved between 20 and 50 on a regular basis, before breaking out to an extreme high not seen previously in 2008, and then hitting abnormally low numbers. It could be that the TED spread is just reestablishing its old range. While this current rise is certainly signaling some upheaval in the market, it might not be signaling the kind of upheaval we had in 2008.
However, I have to tell you that I take a step back in my trading when the TED spread is breaking out of its then-current channeling behavior, whatever the levels of the most recent channel. That's why I'm covering this topic in this space devoted to options trade. I wanted to remind traders that this spread has prompted me to offer warnings of late and it still has me on the edge of my seat.
I would tell bears that if the TED spread approaches 45-50, I would be aware that these numbers mark levels from which the TED spread most often used to turn back, with markets rallying during the downturn. If I had amassed profits in bearish trades and the TED spread was approaching 45-50, I would make plans to protect my bearish profits.
I would warn bulls that as long as the TED spread is soaring higher, we can't count on it finding resistance at the top of its historic 20-50 range, and this behavior isn't typically good for markets. A rise in the TED spread is one way we can look underneath the equity markets and ascertain whether our footing is safe. It doesn't feel that way right now.
If the TED spread should pull back next week, support may be waiting in the 26.60-29.20 range, and may be particularly strong in the 25.00-25.40 range. Market participants should be aware that the TED spread could find support and head up again. We can't be certain whether such a test will result in a collapsing of TED spread values or a renewed bounce.
As of the publication of this article, though, the TED spread is climbing, and that's not good for equity markets.
I want to conclude by telling subscribers who might be in the path of the hurricane this weekend that I hope all remain safe. I grew up in Port Arthur during a time period when many hurricanes evacuated our area, so my heart is certainly with you.